Production/Producer Choice

Lecture 5 & 6
The Production Decisions of
a Firm
1. Production Technology; We need a
practical way of describing how inputs
(such as labor, capital, and raw
materials) can be transformed into
outputs (such as cars and televisions).

2. Cost Constraints; Firms must take into

account the prices of labor, capital, and
other inputs.

3. Input Choices; Given its production

technology and the prices of labor,
capital, and other inputs, the firm must
choose how much of each input to use
in producing its output.
Why do Do we really need firms to produce cars? Why couldn’t
cars be produced by a collection of individuals who
firms exist? worked independently and contracted with each other
when appropriate, rather than being employed by
General Motors?

If we need to redesigned car then it will be difficult to

renegotiate…

Theory of the firm Explanation of how a firm makes

cost-minimizing production decisions and how its cost
varies with its output.
The Technology of
Production
Factors of production Inputs into the
production process (e.g.,labor, capital, and
materials).
The Production Function
Production function Function showing the highest output that a firm can produce for every
specified combination of inputs.

Q=f(K, L)
The Short Run Vs Long run
Short run; Period of time in which quantities of one or more production
factors cannot be changed.

Long run; Amount of time needed to make all production inputs variable.
 Production with One Variable Input(Labor)
Amount of Labor(L) Amount of capital(k) Total Output(Q) Average Product(Q/L) Marginal Product

0 10 0 - -

1 10 15 15 15

2 10 40 20 25

3 10 69 23 29

4 10 96 24 27

5 10 120 24 24

6 10 138 23 18

7 10 147 21 9

8 10 152 19 5
Average Product and Marginal Product
Average product; output per unit of a particular input.

Marginal product; Additional output produced as an input is increased by one

unit.
The Slope of
the Product
Curve
Reason behind the shape of the total product: Law
of diminishing marginal rate of return.

Rational produce will always produce in the second

stage.
 The average product and marginal product curves

Average Product of
are closely related. When the marginal product is
greater than the average product, the average

Labor Curve and product is increasing.

Marginal Product of when the marginal product is less than the average
product, the average product is decreasing.

Labor Curve
The effect of
technological
Improvement
Malthus and The Food Crisis

The law of diminishing marginal returns was central to the thinking of political
economist Thomas Malthus (1766–1834).6 Malthus believed that the world’s limited
amount of land would not be able to supply enough food as the population grew. He
predicted that as both the marginal and average productivity of labor fell and there
were more mouths to feed, mass hunger and starvation would result.
 Production with Two Variable
Inputs

Isoquant; The curve showing all possible combinations of inputs that yield the same
output.
Production with
two Variable
input
Isoquant Map
Isoquant map; Graph combining a number
of isoquants,

used to describe a production function.

Substitution Among Inputs/ Marginal Rate
of Technical Substitution.
Marginal rate of technical substitution (MRTS) Amount by which the quantity of one input can be reduced
when one extra unit of another input is used, so that output remains constant.
Marginal Rate of
Technical Substitution
Amount by which the quantity of one input
can be reduced when one extra unit of
another input is used, so that output remains
constant.

Diminishing MRTS
The marginal rate of technical substitution between two inputs is equal
to the ratio of the marginal products of the inputs.
Production Functions-Two Special Cases

Perfect substitute of inputs

For example music instruments

 Perfect Complements
input

For example Jackhammers...

Return to Returns to scale Rate at which output increases as inputs are

Scale
increased proportionately.

Increasing returns to scale: Situation in which output more than

doubles when all inputs are doubled. (Airlines)

Constant returns to scale: Situation in which output doubles

when all inputs are doubled. (CAR wash)

Decreasing returns to scale: Situation in which output less than

doubles when all inputs are doubled. (Power distribution)
Thanks